Supply-side policies

• State the five goals of supply-side policies and explain how each is meant to be reached.
• Distinguish market-based from interventionist policies and trace the mechanism of each policy.
• Draw the AD/AS diagram for a supply-side policy, with LRAS1 moving to LRAS2, and the labour-market diagram for a minimum wage.
• Separate the demand-side effects of supply-side policies from the supply-side effects of fiscal policies.
• Evaluate both policy families against growth, unemployment and inflation, using time lags, cost to the budget, equity, the environment and vested interests.

A supply-side policy is a government measure intended to raise the economy's productive potential or the efficiency with which resources are used. Potential output is the sustainable level of production associated with the economy's productive capacity; it is not necessarily today's actual real GDP. Productivity is output per unit of input, for example output per worker-hour. It differs from total production and from working longer hours.

Supply-side policies have five goals. Each is a route by which the supply side of the economy, shown by long-run aggregate supply (LRAS), is improved.

1. Long-term growth by increasing the economy's productive capacity. More or better factors of production, or better technology, raise the output the economy can sustain. LRAS shifts right and potential output rises, which is the only kind of economic growth that can continue once existing resources are fully used.
2. Improving competition and efficiency. Firms that face rivals must cut costs, improve quality and innovate to keep their customers, so resources move toward the firms and uses in which they produce most.
3. Reducing labour costs and unemployment through labour-market flexibility. When wages and employment adjust more easily, the cost of hiring falls, firms take on more workers and people without work move into jobs sooner. Structural and frictional unemployment fall, and with them the natural rate of unemployment.
4. Reducing inflation to improve international competitiveness. Greater capacity and lower costs slow the rise in domestic prices, which makes the country's goods cheaper relative to foreign goods.
5. Increasing firms' incentives to invest in innovation by reducing costs. Lower costs, whether from lower business taxes, cheaper inputs or lighter regulation, raise the expected profit from an investment and leave firms more retained profit to pay for research, new products and new methods.

The fourth goal links the domestic economy to trade. When productive capacity grows, LRAS shifts right and firms' unit costs fall, so the price level rises more slowly than it otherwise would. If domestic prices rise more slowly than the prices of trading partners, exports become cheaper relative to foreign goods and imports become relatively dearer, so net exports tend to rise. The gain lasts only if it is not offset by a rise in the exchange rate or by equally low inflation abroad.

Market-based policies use competition, incentives and more flexible markets to improve supply. They still depend on institutions, law and enforcement. Interventionist policies are active public measures to improve resources, capabilities or coordination, such as education and infrastructure. The distinction describes the mechanism, not whether a government is involved: both kinds are government policies.

The vocabulary of the topic follows from the two families. Deregulation removes or simplifies rules, with effects that depend on which rules are changed. Privatisation transfers ownership of a public enterprise or asset to the private sector; it is not the same thing as more competition. Trade liberalisation reduces barriers to international trade. Human capital is the productive knowledge, skills and capabilities embodied in people. Labour-market flexibility is the ability of wages and employment arrangements to adjust; its different forms have different effects on security, bargaining power and productivity.

An economy may have unemployed resources because demand is weak, or may face a limit because resources, skills or technology constrain production. Supply-side policy targets the second problem and the efficiency with which resources are used. It can also reduce structural unemployment, where workers' skills or locations do not match the jobs available. It is not a quick substitute for demand support during a severe recession.

Better skills, technology, health or infrastructure raise the output that can be produced from given inputs. In the monetarist/new classical AD/AS model this shifts LRAS to the right, from LRAS1 to LRAS2, and potential output rises from Yf1 to Yf2. Because the same improvements lower firms' unit costs, SRAS shifts right as well. With aggregate demand unchanged, the economy moves to a new equilibrium with higher real GDP and a lower price level than it would otherwise have had. This is the standard supply-side diagram, and it is why supply-side policies are said to raise growth and ease inflationary pressure together.

Strictly, a shift of LRAS alone would leave the short-run intersection of AD and SRAS where it was and add spare capacity; actual output reaches Yf2 because lower costs shift SRAS right or because AD grows.

In the Keynesian diagram, greater capacity moves the vertical section of the Keynesian AS curve to the right, from Yf1 to Yf2, so output can expand further before strong pressure on prices develops. The horizontal section does not move. If AD rises as well, output increases further and the effect on the price level depends on the relative size of the two shifts. In both models the result rests on two conditions: the policy must in fact raise capacity, and demand must be sufficient to use it.

Deregulation. Barriers to entry or weak competitive pressure can allow high prices and slack performance. Deregulation removes or simplifies rules that restrict what firms may do, such as a licence that limits the number of firms in a market. The chain runs from fewer restrictions to the entry of new firms, from entry to stronger competitive pressure on every firm, and from that pressure to lower costs, better quality and innovation, so productivity rises and LRAS shifts right. Entry may remain difficult where large fixed costs or network effects favour the established firm. The gain also depends on which rules are removed: removing safety or environmental rules reduces private costs while raising social costs.

Anti-monopoly regulation. A firm that dominates its market can keep prices high and has little reason to cut costs or innovate. Anti-monopoly regulation forbids agreements between firms to fix prices or share out markets, stops a dominant firm from using its position to exclude rivals, and allows a merger to be blocked if it would greatly reduce competition. It is a regulation, yet it counts as market-based because its purpose is to make markets more competitive, not to replace them. The result is the same pressure on costs and prices that deregulation aims at, reached by enforcing rules instead of removing them. It works only if the authority can detect the conduct and impose penalties large enough to deter it.

Privatisation. Privatisation transfers ownership of a public enterprise or asset to the private sector. Private owners face the profit motive and the scrutiny of shareholders, and can raise finance for investment from private capital markets, so costs may fall and investment may rise. The sale also brings the government one-off revenue, which is a fiscal effect and separate from any gain in productivity. Changing ownership does not in itself remove monopoly power: a private monopoly may restrict output, raise prices or stop providing unprofitable services. The gain in efficiency therefore depends on whether the firm faces competition or effective regulation after the sale.

Trade liberalisation. Trade liberalisation reduces barriers to trade such as tariffs and quotas. Domestic firms gain cheaper access to imported inputs and face competition from foreign firms, which pushes them to cut costs and to specialise in what they produce relatively efficiently. Some workers and firms bear adjustment costs, because industries that cannot compete shrink. A displaced worker does not immediately find a more productive job, so structural unemployment can rise for a time. The benefits are larger where infrastructure, skills and the ability to move between regions let resources shift into the expanding industries.

Incentive-related policies cut taxes in order to raise the reward for working, investing and taking risks. A cut in personal income tax raises the take-home pay from an extra hour of work or from taking a job, so the supply of labour may increase: some people work longer hours, and some who were not working, or were living on benefits, enter employment.

A cut in business tax, the tax on firms' profits, raises after-tax profit. This increases the expected return on a new investment and leaves firms more retained profit with which to finance it. A cut in capital gains tax, the tax on the gain made when an asset such as shares or property is sold for more than it cost, raises the reward for investing in firms and for starting a business. If people work, invest and innovate more, the quantity and quality of labour and capital rise and LRAS shifts right.

Labour-market policies aim at greater labour-market flexibility, so that wages and employment adjust more easily to changes in the demand for and supply of labour. The three main ones are reducing the power of labour unions, reducing unemployment benefits and abolishing minimum wages.

• Reducing the power of labour unions. A labour union bargains for its members as a group and can hold wages above the level that would clear the market, or resist changes in working practices. Laws that restrict strikes or end compulsory membership weaken that bargaining power. Wages then follow market conditions more closely and firms' labour costs fall, so firms hire more workers and aggregate supply increases. Union members lose pay and job security.
• Reducing unemployment benefits. Cutting the level of unemployment benefits, or the time for which they are paid, raises the cost of remaining unemployed. People search harder and accept job offers sooner and at lower wages, so frictional and structural unemployment fall. A lower benefit does not create suitable vacancies, childcare or relevant skills, and it lowers the income of those who still cannot find work.
• Abolishing minimum wages. A minimum wage set above the market-clearing wage makes low-paid labour more expensive than it would otherwise be. Removing it lets the wage fall, so firms hire more low-paid workers.

These changes alter hiring costs, job-search incentives, bargaining and income security together. Reduced security can weaken the willingness of firms and workers to invest in training, and can lower morale, so part of the gain in flexibility may be lost in lower productivity.

The model behind the third policy is a competitive labour market: a downward-sloping demand for labour DL, an upward-sloping supply of labour SL, and a minimum wage Wmin above the equilibrium wage We. At Wmin the quantity of labour supplied, Qs, exceeds the quantity demanded, Qd, and employment is set by demand at Qd. Lowering the floor toward We, or abolishing it, raises the quantity of labour demanded and removes the excess supply, while reducing the wage of the workers affected. The excess supply in one market is not the national unemployment rate: an economy contains many labour markets, and the total also depends on aggregate demand, on which workers the law covers and on whether employers comply.

Education and training. Relevant learning adds to human capital: it improves skills, enables workers to use new technology and reduces the mismatch between the unemployed and the vacancies available. Labour productivity rises and structural unemployment falls, so LRAS shifts right. Governments provide or subsidise education and training because part of the benefit goes to other people (a more productive worker raises the output of colleagues and of later employers), which is a positive externality, so private spending on them is lower than is best for society.

A rise in spending is not the same as a rise in skills. The quality of the programme, whether learners complete it, employers' demand for the skills taught and equal access all matter. Adults may face barriers of time, childcare and lost income even when fees are subsidised.

Health care. Improving the quality and quantity of health care, and access to it, reduces absence from work through illness, lengthens working lives and improves workers' physical and mental capabilities, so both the quantity and the productivity of labour rise. Health also matters for well-being in its own right, not only for GDP. The effect on capacity depends on which health problems are treated, on the quality of the services and on who can reach them: care that reaches only people who are already healthy and well paid adds little to the labour force.

Research and development. R&D creates new knowledge and turns it into new products and new methods of production, which is the source of technological progress. Knowledge spreads to other firms and the outcome of research is uncertain, so private firms invest less in it than is best for society. Governments respond by funding universities and research institutes, by giving tax relief or grants for firms' spending on R&D, and by forming partnerships with firms. A successful discovery is not assured, the government has to choose and monitor what it supports, and the gains may be captured by a few firms.

Infrastructure. Reliable transport, power, water and communications reduce delays and costs for firms and widen the markets and the labour force they can reach. Governments provide much of it because the benefits are spread over many users who cannot easily be charged. Construction adds to aggregate demand years before the assets become productive. A poorly chosen project creates little useful capacity while imposing maintenance and environmental costs, so the test of a project is how much it is used and what it adds to production, not how much is spent on it.

Industrial policies. Industrial policies support chosen industries, for example with subsidies, tax relief, low-interest loans or protection from imports, in order to help them grow. The case for them is that a new industry may need time and scale to build skills and suppliers before it can compete, and that no single firm will invest until others do. The risks are favouritism and lobbying by the firms supported, long protection of inefficient firms, and retaliation by trading partners. Support with review dates and rules for withdrawal is more likely to raise capacity. A subsidised industry that later expands does not prove that the policy worked, because it might have grown without the support.

Supply-side policies have demand-side effects, and these come first. When the government pays for training, a railway or a research grant, government spending rises, so AD shifts right in the short run. A cut in income tax raises disposable income and consumption, and a cut in business tax may raise investment, with the same effect on AD. Later, once workers have usable skills and firms employ them, or once the railway is open, LRAS shifts right. The two effects are separate shifts at different times: the demand-side effect is quick, and the supply-side effect arrives after a long lag and only if the training fits the jobs available.

Fiscal policy has supply-side effects. Government spending and taxation are normally used to manage AD, but what the government spends on, and which taxes it changes, also affect productive capacity. Spending on education, health, research and infrastructure adds to human and physical capital, so a budget built around them shifts LRAS right in later years as well as AD now. Lower taxes on income and profits can strengthen the incentives to work and invest. The reverse also holds: a fiscal contraction that cuts public investment reduces AD today and slows the growth of potential output later.

The timing matters for inflation. When AD and LRAS both shift right, real GDP rises with little change in the price level, so growth need not be inflationary. If the economy is already close to full employment, the demand-side effect arrives before the extra capacity exists and can add to demand-pull inflation in the meantime.

Lowering fees can help adults acquire relevant skills, but credits issued do not prove additional learning, productive employment or gains in productivity. Lost earnings, care duties, the quality of courses and employers' demand for the skills may still limit participation or the use of what is learned. The evidence that would show an effect is completion, skills acquired and later employment and pay, compared with similar workers who did not receive the credit. Participation alone is not impact.

The case also shows the two constraints on interventionist policy. Cost: the credit is paid from the government budget, so it has an opportunity cost in other spending, or must be financed by taxes or borrowing. Time lag: a worker must choose a course, complete it and move into a job that uses the skill before any output is added, which takes years, while the cost falls on the budget at once.

A supply-side policy works when it matches the constraint that is holding the economy back. Skills support is more convincing where relevant vacancies exist and workers are helped to take part. Competition reform is more convincing where it removes a specific barrier and keeps the protections that correct market failures. Infrastructure is more convincing where congestion or unreliable services limit production. In a recession caused by deficient demand, capacity alone does not generate sales, so supply-side measures need demand support alongside them.

The gains and losses fall on different groups. Consumers gain from lower prices and more choice when competition increases. Firms gain from lower costs and taxes, though firms that were protected lose. Workers gain if jobs are created and higher productivity raises pay, but those who relied on unions, benefits or a minimum wage lose income and security. Taxpayers bear the cost of interventionist policies and of tax cuts. Because the losses come at once and the gains years later, supply-side policies are easier to justify for the long run than for the short run.

• Match a policy to the cause of weak performance: deficient demand, skills mismatch, barriers to entry or infrastructure constraints.
• Privatisation is a change of ownership, not proof of competition. Deregulation can shift private costs onto society.
• Spending on training does not prove a gain in productivity, and extra capacity does not guarantee sales.
• 'No burden on the government budget' is a strength of market-based policies. It holds for deregulation and privatisation. It does not hold for tax cuts.
• The groups affected differ: workers (security and pay), consumers (prices, access and quality), firms (incentives), taxpayers (opportunity cost) and the environment.